Ask Liz Weston

Get smart with your money

Taxes

Q&A: Keeping an eye on your financial planner

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Dear Liz: I’m a fee-only financial planner with a quick comment regarding the investor who complained about a financial advisor who ran up a huge capital gains tax bill. I’ll bet that the vast majority of the gains came from selling the person’s initial investments to re-position them according to the advisor’s recommendations. That seems most likely given the gains seemed to be huge (implying the current investments had been in place for a long time) and the client’s balance didn’t seem to grow much at the same time. Of course, that’s not necessarily an excuse — accounts with unrealized capital gains need to be handled very carefully by an advisor. And you are dead-on with the main point of your response: Giving an advisor discretionary trading status is risky. I would add to that the client doesn’t seem to know the advisor’s investment strategy, so that’s another disconnect. I’m glad that fee-only gets a lot of positive comments in the financial press, but you’re correct that you still need to move with caution.

Answer: Advisors are in an unenviable position when they’re trying to fix a portfolio that hasn’t been properly diversified over the years. Big gains build up because the investor doesn’t want to sell and pay capital gains taxes. By refusing to sell some winners occasionally, though, those winners can comprise an ever larger share of the portfolio, making it more and more risky. A concentrated portfolio can fall more in a bad market and gain less in a good one than a portfolio that’s properly diversified.

So the advisor may have been doing what needed to be done, but the fact that the investor didn’t understand what the advisor was doing or why indicates a breakdown in communication, at the very least. No one should give an advisor blanket permission to trade an account without understanding the advisor’s strategy and being willing to monitor how it’s being carried out.

Q&A: Giving a gift with a built-in loss

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Dear Liz: You recently answered a question about the tax implications of gifting stock to children. You mentioned that if the stock had lost value since its purchase, the children could use the loss to offset capital gains or, in the absence of gains, up to $3,000 a year of income, with the ability to carry over that loss to subsequent years until it’s used up.

But if a stock has a built-in loss, why not sell it, realize the loss and give the kids the cash? That way, the loss is sure to be recognized unless the donor dies before fully utilizing the capital loss or the carryover. If the child really wants that particular stock, he or she can use the cash to buy it. The children would have to be mindful of the wash-sale rules that prohibit deducting a loss if a related party buys the same stock, but waiting 31 days would be enough to avoid that.

In my view, there’s rarely a good reason to gift a stock (or most other assets) that has a built-in loss.

Answer: Exactly. Selling the asset and taking the tax benefit usually makes more sense than transferring the shares. The loss essentially evaporates, because the assets get a new value for tax purposes when transferred.

Selling losing stocks is certainly better than bequeathing them to your heirs. The loss essentially evaporates at your death, because the assets get a new value for tax purposes, so no one gets the potential tax break.

Q&A: If your job reimburses you for education costs, can you still get a tax deduction?

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Dear Liz: I established a Coverdell Education Savings Account for my son about 20 years ago. My son has since graduated, and there is still about $12,000 left in that account. He has worked a few years and now is going to graduate school while still being employed. His employer will do education reimbursement.

How should we withdraw the funds to qualify for the education expense deduction come tax time?

Answer: Congress recently eliminated the tuition and fees deduction, but the American Opportunity Tax Credit and the Lifetime Learning Credit remain for 2018. For you to claim an education credit, however, your son would have to be your dependent. If your son is working full time, he’s probably not a dependent. He may be able to take a credit, but only for qualified education expenses that aren’t reimbursed by his employer or paid by a Coverdell distribution. Taxpayers aren’t allowed to double-dip — or potentially, in this case, triple-dip — on education tax benefits.

If your son incurs education expenses in excess of what his employer reimburses, then funds in the Coverdell ESA could be used to pay for those costs or reimburse your son for the additional out-of-pocket education expenses he paid in the same year as the distribution, said Mark Luscombe, principal tax analyst at Wolters Kluwer Tax & Accounting. Once the Coverdell is depleted, your son may be able to take a credit for any remaining qualified education expenses.

Q&A: Selling a home you’ve shared with tenants

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Dear Liz: I am 53 and own a home in which I live and rent out rooms. Every year I pay my taxes on the rental income and get to deduct depreciation.

How does this affect the taxes I will pay on the home when I sell it? Will I be able to claim the $250,000 exemption? I may live in this home until my death and leave it to my children. How would the rental depreciation affect their stepped-up basis and any taxes they might have to pay?

Answer: Renting rooms is similar to taking the home office deduction in the Internal Revenue Service’s eyes. In both cases, you have to recapture any depreciation, but the business use doesn’t affect your ability to take the home sale exclusion.

The home sale exclusion allows you to exempt from capital gains taxes up to $250,000 of home sale profit. (The exclusion is per owner, so a married couple potentially could exempt up to $500,000.) You’re eligible for the exclusion if you have owned and used your home as your primary residence for at least two years out of the five years before the sale. You will have to pay income taxes on the amount of depreciation you deducted over the years. That depreciation amount is added back as income on your tax return.

If the space you rented out had not been within your living area — if it were a separate apartment or retail space — then different rules would apply.

If you decide to bequeath the home at your death rather than selling it, your heirs won’t have to pay the depreciation recapture tax — or capital gains taxes on any appreciation that took place while you owned it. Instead, the home’s tax basis will be “stepped up” to its current market value.

If they sell it soon after inheriting it, they won’t owe much if any tax on the sale. If they hang on to it before selling, they’ll owe taxes only on the appreciation that took place while they owned it. If they move in and make it their primary residence, they too could qualify for the $250,000-per-person home sale exclusion once they have owned the home, and used it as their primary residence, for at least two of the five years before they sell it.

Q&A: A large foreign bequest could trigger U.S. taxes

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Dear Liz: I have received an inheritance of $445,000 from a relative who died out of the country. Do I have to pay income tax on this money?

Answer: If you inherited from someone who was a U.S. citizen who lived abroad, then that person’s estate may be subject to U.S. estate taxes. The estate would have to be quite large, though. In 2017, estates worth less than $5.49 million per person were exempt from the tax. In 2018, the amount was raised to $11.18 million.

If you had paid any taxes on your inheritance to a foreign government, you could take a tax credit on your U.S. tax return for that amount.

Otherwise, you probably won’t owe any taxes. The federal government and most states don’t levy inheritance taxes on people who receive bequests. The exceptions are Iowa, Kentucky, Nebraska, Maryland, Pennsylvania and New Jersey, which do levy taxes on inheritances. All exempt spouses, and some exempt other immediate relatives.

Q&A: Here are some tips for getting more retirement money into accounts with tax advantages

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Dear Liz: My wife and I are about 35. I’m self-employed and contribute to a SEP IRA. My wife contributes to a workplace retirement plan. We don’t qualify to contribute to Roth IRAs. In order to get more money into retirement accounts, would you recommend doing back-door Roth contributions? What else is there to do to get retirement money into accounts that will have a tax benefit now or later?

Answer: Roth IRAs don’t provide an upfront deduction, but withdrawals are tax-free in retirement. That makes them especially enticing to people who expect to be in the same or higher tax bracket in retirement — mostly higher-income people and good savers.

People who earn more than certain limits, however, are prohibited from contributing directly to a Roth IRA. For 2018, direct Roth contributions aren’t allowed for people whose modified adjusted gross incomes exceed $199,000 for married couples filing jointly or $135,000 for single filers.

Several years ago, however, Congress eliminated income limits on who was allowed to convert a regular IRA to a Roth IRA. That change created the back-door Roth strategy, in which a high-income taxpayer contributes to a regular IRA and then converts the money to a Roth.

The strategy works best for people who don’t already have a large IRA filled with pre-tax contributions and earnings. When you convert all or some of an IRA to a Roth, you have to pay a proportionate amount of income taxes on the conversion based on all of your IRA holdings. If you don’t have an existing IRA and don’t deduct the IRA contribution, you’ll owe little if any taxes on the conversion.

The IRS hasn’t specifically blessed or banned the back-door Roth strategy, so it remains somewhat controversial. Many investing and brokerage sites promote it. Some proponents, however, recommend letting several months pass between the contribution and the conversion. The idea is to avoid IRS scrutiny by making the transactions appear to be separate decisions rather than one clearly meant to get around the contribution limits.

If you want to stay out of gray areas and potentially contribute more cash to your retirement, consider setting up a solo 401(k). This version of the popular workplace plan is meant for self-employed business owners with no full-time employees other than themselves and their spouses. Plan participants under age 50 can contribute up to $18,500 a year. Those 50 and older can contribute up to $24,500. The plan can have a Roth and an after-tax contribution option in addition to a pre-tax option. In addition, the business can make a 25% annual profit-sharing contribution (or 20% if the business is a sole proprietorship or single member LLC). The combined maximum of participant and business contribution is $55,000 for those under 50 and $61,000 for those 50 and older.

If you’re able to contribute more than these amounts each year, consider a traditional defined-benefit pension. Those involve considerable set-up and ongoing costs, so consult a tax pro to see if it’s a good fit.